IBD Editorials

Krugman's Depression

06/28/2010 06:30 PM ET

Economic Policy: Nobel Prize-winning economist Paul Krugman says the U.S. is in the "early stages of a third Great Depression." If he's right, it's only because American policymakers have been following his advice.

Hell knows no wrath like that of an economist scorned  especially one on the left of the political spectrum. Case in point: New York Times columnist and sometime economist Paul Krugman. The world is going to hell in a handbasket, Krugman suggested this week, thanks in large part to its refusal to follow his advice to the letter.

Actually, he has it exactly backward. Krugman was among those who encouraged the new Obama administration and the Democratic Congress to spend massive amounts of money early on in a kind of Keynesian frenzy to shock the moribund economy back to life.

It didn't work. With a stimulus  a deficit, that is  of nearly 11% of GDP, our economy is barely growing, while unemployment remains shockingly close to 10% of the adult working population.

This even prompted our nation's vice president, Joe Biden, to admit last weekend: "There's no possibility to restore 8 million jobs lost in the Great Recession."

And he's right  at least with current policy, which is based on massive spending, new tax hikes, trillion-dollar deficits for decades to come and tight government control of vast swaths of our nation's economy, from banking to autos to energy.

Krugman recognizes, too, that it's a "failure of policy."

Only problem is, he completely misdiagnoses the problem: "Around the world  most recently at last weekend's deeply discouraging G-20 meeting  governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending."

This has happened the world over. To their credit, even the socialist nations of Europe now recognize this. They were behind the move at the G-20 to reduce government budgets. Only the neo-socialist Obama administration and its pals in Congress don't get it.

Krugman faults policymakers for failing to learn from history. Since he used the word "Depression," let's look at the last one.

It's an enduring myth that the Great Depression was caused by inadequate government "stimulus," of the sort Lord Keynes and President Obama would have approved. In fact, as a study by economist Randall Holcombe shows, under President Hoover, who served from 1929 to 1933 just as the Depression got under way, real per-capita spending surged 82%. That was even greater than the 74% rise from 1933 to 1940 in FDR's time.

So why did that slump last so long? UCLA economist Lee Ohanian studied that question. His conclusion: "The main culprit appears to be government policies that restricted competition." Indeed, stupid economic policies, including higher taxes, trade protectionism and the government's foolish effort to prop up wages, added seven years to the Depression. But for the government's tinkering, we would have exited that rut in the early 1930s, says Ohanian.

Economists Charles Rowley of George Mason University and Nathanael Smith of the Locke Institute came to a similar conclusion in their study of Keynesian policies during the 1930s:

"(FDR's) interventionist policies and draconian tax increases delayed full economy recovery by several years by exacerbating a climate of pessimistic expectations that drove down private capital formation and household consumption to unprecedented lows."

Sound familiar? It should. Others, ranging from economic historian Amity Shlaes to economist Robert Higgs, tell the same story.

Today, Obama is following a script eerily similar to the one followed by Hoover and FDR: He wants to spend wildly, raise taxes on all Americans, erect trade barriers and protect unions, his biggest supporters, to boost their wages at others' expense.

The only difference this time is the Fed has refused to let the money supply contract by a third, as it did during the Depression, deepening the economy's collapse.

The hole in which we find ourselves is the result of bad policy responses to a short-term financial crisis. We'll pay for it with an enfeebled economy for years to come.

And if, as Krugman believes, we are about to enter a global depression, it's only because our policymakers were foolish enough to take his advice.